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New Developments in the Texas Franchise Tax

On May 18,
2006, Texas governor Rick Perry signed legislation that
completely revamped the Texas franchise tax law (2006 TX
H.B. 3). Under the new law, many more entity types are now
required to submit a franchise tax report. Most notably,
most partnerships doing business in Texas must now file
the report. Previously, partnerships did not have a filing
requirement.

Another major change under the new
law is the requirement that entities doing business in
Texas are now subject to combined reporting, as opposed to
the separate reporting filing method under the old law.
(For more on the Texas franchise tax, see Chisholm,
"Texas
Comptroller Provides Rules on the Texas Franchise
Tax," Tax Clinic, 39 The Tax Adviser 499
(August 2008).)

This item describes some of the
unusual facets of the new law and some recent developments
that practitioners should be aware of.

Revenue
Below $434,782 Is Tax Free

There are four different
situations in which taxable entities filing the Texas
franchise tax report will owe no tax:

The entity is a
passive entity as defined in Chapter 171 of the Texas
Tax Code (TX Tax Code §171.0003). Note: Rental income is
not passive per the Texas Tax Code.

The
entity has zero Texas gross receipts.

The
entity has a tax due of less than $1,000 (TX Tax Code
§171.002(d)).

The entity has $434,782 or
less in total revenue.

As originally passed
in 2006, the new Texas franchise tax law actually used an
amount of $300,000 for item 4 above. Texas Tax Code
§171.002(d) continues to reflect the $300,000 amount.
However, per a September 17, 2007, Texas state comptroller
press release, this amount is actually $434,782. This
unusual figure is a result of tax discounts made available
by the June 17, 2007, technical corrections bill (2007 TX
H.B. 3928) that amended the May 18, 2006, law.

How
exactly does a total revenue amount of $434,782 result in
no tax due on a Texas franchise tax report? One method by
which entities calculate franchise tax due under the new
Texas franchise tax law is by multiplying total revenue by
a rate of .575% (.00575) (TX Tax Code §171.1016). Under
this "E-Z computation" method, a total revenue
amount of $434,782 will result in just under $2,500 tax
due ($434,782 × .00575 = $2,499.9965). One of the
provisions of the technical corrections bill was to allow
entities with $900,000 or less in total revenue to
experience at least some relief from the new margin tax
(TX Tax Code §171.0021). Under this provision, entities
with total revenue greater than or equal to $400,000 and
less than $500,000 are allowed a tax discount equal to 60%
of the tax otherwise due.

An entity with $434,782
in revenue can therefore further reduce its tax due by a
discount of just under $1,500 ($2,499.9965 × .60 =
$1,499.9979). The tax due after taking the discount is
just under $1,000 ($2,499.9965 – $1,499.9979 = $999.9986).
Because the tax due for this entity is now just under
$1,000, its franchise tax liability is zero, per
§171.002(d).

An item of note for tax preparers who
use tax preparation software to generate Texas franchise
tax reports: Most tax software packages use rounding when
generating tax reports. When rounded, the "just
under" amounts used here would result in a calculated
tax amount of $1,000, as opposed to the less-than- $1,000
amounts required in §171.002(d). As a result, when an
entity has $434,782 in total revenue, many software
packages will generate an incorrect tax due amount of
$1,000 instead of zero. In these situations, tax preparers
would need to enter input overrides to provide the correct
"no tax due" calculation.

Cost of Goods
Sold

Under the new Texas Tax Code §171.101, entities
calculate their franchise tax base in one of two ways:

An E-Z
computation, in which the franchise tax base is equal to
total revenue. The example above reflects a franchise
tax base calculated under this method.

A
franchise tax base that is equal to the taxable entity's
margin.

A taxable entity's margin is
generally the lowest of the following three calculations:

Total
revenue minus cost of goods sold (COGS);

Total revenue minus compensation; or

Total revenue × 70%.

In using total
revenue minus COGS to calculate its margin, an entity must
take into account the following statement in the
instructions to the new Texas franchise tax report:

In no instance will COGS for franchise tax
reporting purposes equal the amount used for federal
income tax reporting purposes or for financial accounting
purposes. This amount can not be found on a federal income
tax report or on an income statement. It is a calculated
amount specific to franchise tax. [Instructions to Form
05-158, Texas Franchise Tax Report (March
2008).]

The Texas state comptroller never
expressly said why it made such a definitive statement with
regard to the Texas COGS number. However, a review of the
short history of the Texas COGS deduction reveals some
possible reasons for this comptroller declaration.

It was
not determined until January 11, 2008, when the Texas
state comptroller issued Policy Letter Ruling No.
200801034L, that an entity's beginning inventory could, in
fact, be used in the Texas COGS equation. Texas had
originally stated that it did not want costs incurred
prior to the new franchise tax law to be included in COGS
in any way. As the federal COGS calculation does use a
beginning inventory amount, the Texas COGS would be
different based on this fact alone.

Prior to the
letter ruling, Texas correctly reasoned that allowing a
beginning inventory amount would allow amounts incurred
but not expensed in a prior year to be part of the Texas
COGS equation. The letter ruling now allows for using a
beginning inventory amount. Perhaps the quotation above
was made part of the Texas instructions prior to this
January 11, 2008, ruling, which allows a more federal-
like treatment of the COGS equation.

In addition
to the inventory discussion above, the Texas COGS amount
also allows for a maximum of 4% of general and
administrative overhead costs to be included in the COGS
deduction. There is, of course, no similar federal law
regarding this 4% item. This difference could also lead to
a difference between federal and Texas COGS. However, a
close review of the Texas law reveals that not all
entities will be able to take advantage of this 4%
addition.

Texas relaxes its position: In the
July 2008 issue of Texas Tax Policy News, a state
comptroller newsletter, the state of Texas now says that
it is only "very unlikely" that the Texas COGS
number will equal some other COGS amount. The "no
instance" language has been removed. Perhaps some of
the analysis above was the reason for this latest policy
change.

Service industry companies: Generally,
a taxable entity in the service industry will not have
COGS (TX Tax Code §171.1012). However, a rule issued by
the state comptroller notes that service companies can
deduct cost of goods sold for "costs otherwise
allowed by this section in relation to the tangible
personal property sold" (34 TX Admin. Code
§3.588(c)(6)).

The frequently asked questions portion
of the comptroller's website gives an example of an oil
change service business that is allowed to generate a COGS
number by computing the cost of oil filters and oil that
is included in the performance of the oil change. A crop
duster business and a veterinarian's practice are also
listed as examples of businesses that perform "mixed
transactions" that may qualify for a COGS deduction.
It appears that a taxpayer will indeed be able to count as
COGS certain items consumed or transferred in connection
with providing its services.

Observation: Even though the
comptroller is apparently allowing the calculation and
deduction of a COGS amount for entities that are generally
thought to be service entities, it is still entirely
possible, if not probable, that service entities will
benefit more by electing the compensation deduction.

Newly Taxable Entities Should Formally Dissolve

One of the more notable changes brought about by the new
Texas franchise tax is that many additional entity types are
required to file a franchise tax report. Reports originally
due on or after January 1, 2008, are required to be filed by
these entities. The Texas state comptroller's website
provides a summary of those entities that were required to
file under the old law and those required to file under the
new law, as shown in the exhibit.

Current
procedures in Texas require those Texas corporations and
limited liability companies (LLCs) that are intending to
close their businesses to formally dissolve with the Texas
secretary of state in order to avoid being subject to the
following year's franchise tax filing requirements (see
Texas Comptroller Publication 98-336D, Requirements to
Dissolve/Terminate, Merge or Convert a Texas
Entity(March 2007).

Recent discussions
with the state comptroller's office reveal that the same
type of procedures will be required of the newly taxable
entities. That is, newly taxable entities will also be
required to formally dissolve their businesses in order to
prevent them from being subject to the following year's
franchise tax requirements. Dissolving an entity that does
business in Texas requires:

Combined
Reporting

For many years, Texas had made it very clear
that separate entity reporting was the required reporting
method for Texas franchise tax purposes. That is, each
separate legal entity chartered or authorized to do business
in the state of Texas was required to file its own Texas
franchise tax report. With the change in the Texas franchise
tax law, the state has implemented mandatory combined
reporting (TX Tax Code §§171.0001 and 171.1014).

Combined
reporting requires that under certain circumstances more
than one entity should be included on a combined Texas
franchise tax report. To determine if entities should be
included on a combined report, a return preparer must
determine if two or more entities are affiliated with
regard to some common ownership. The franchise tax statute
defines an affiliated group as a group of one or more
entities in which a controlling interest is owned by a
common owner or owners, either corporate or noncorporate,
or by one or more of the member entities (TX Tax Code
§171.0001(1)). In addition, for entities to be included on
a combined report, the tax return preparer must determine
if the entities are operating in a way that makes the
entities interdependent on each other's activities.

What if entities that have filed separate reports
later determine that they should have filed a combined
report? On June 24, 2008, the state
comptroller's office added this question to its list of frequently asked questions, and then
amended it on August 11, 2008. In answer to this question,
the comptroller noted, "The entity that filed
incorrectly should submit a letter with their
[sic] name and taxpayer number stating that the
report was filed in error and the entity will report with
a combined group. The letter must also include . . .
authorization to transfer any tax payment from the
member's account to the reporting entity's account."

The comptroller's office did not address the
situation in which entities file extensions and then prior
to filing their original returns discover that only one
combined entity extension should have been filed.
Presumably, the entity that filed incorrectly should
submit a letter with its name and taxpayer number stating
that the extension was filed in error and the entity will
report with a combined group. It would seem that this
letter should also include the name and taxpayer number of
the combined group's reporting entity along with a request
for refund or authorization to transfer any tax payment
from the member's account to the reporting entity's
account.

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